What GE’s Board Could Have Done Differently

Executive Summary

During GE’s long and steep decline, where was the company’s board of directors? While the board was composed almost entirely of independent directors — a distinguished and diversified group of former top executives and other leaders with relevant experience — its structure and processes were poorly designed for effectively overseeing former CEO Jeff Immelt and his management team. Three problems in particular stand out: (1) The board was too big, (2) it had no finance committee, and (3) its audit committee had a blind spot.

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During Jeff Immelt’s tenure as CEO of General Electric, from 2001 until 2017, the company’s stock price fell by over 30%, a decline of roughly $150 billion in shareholder value. Since Immelt’s departure, GE’s stock is down another 30%, as its new CEO, John Flannery, has struggled to cope with the cash flow drain from years of problematic acquisitions, divestitures, and buybacks. Because of these dubious decisions, GE’s ratio of debt to earnings has soared from 1.5 in 2013 to 3.7 in early 2018, according to Moody’s.

So, during GE’s long and steep decline, where was the company’s board of directors? Composed almost entirely of independent directors, it was a distinguished and diversified group of former top executives and other leaders with relevant experience. In my view, however, the structure and processes of the GE board were poorly designed for effectively overseeing Immelt and his management team. There were three problems in particular:

The Board Was Too Big

During most of Immelt’s tenure, the GE board was much too large, with 18 directors. The average size of U.S. public company boards is 11 members, with most boards having between eight and 14. Smaller boards are significantly correlated with better stock performance — 8% to 10% higher, according to a GMI study.

Why? After studying meetings of various sizes, researchers have concluded that the optimal number of participants is seven or eight — small enough for good discussions, but large enough for a diversity of opinions. Sociologists observe that many participants in large meetings engage in “social loafing”: Because of the large size, they do not feel responsible to contribute, and instead are content to rely on others to carry things forward.

Fortunately, in December of 2017 GE’s board downsized from 18 members to 12.

The Board Had No Finance Committee

GE’s board had another major structural defect: It lacked a finance committee. Before 2018, it had the three standard board committees — governance, compensation, and audit — plus a technology and risk committee to cover important areas such as product risk, cybersecurity, and technological innovation.

As I have explained elsewhere, a finance committee is critical for a board in complex public companies like GE, which are involved in a broad range of retirement plans, stock buybacks, and large acquisitions. Since the Sarbanes–Oxley Act in 2002, audit committees do not have enough time to carry out their prescribed list of detailed duties as well as to deal effectively with these broader issues of capital allocation.

If the GE board had had a finance committee, the board might have done a better job of overseeing the design and funding of its retirement plans. When Jack Welch stepped down as CEO in 2001, GE’s defined benefit (DB) plan was sitting on a surplus of $14.6 billion. By the end of 2017, this pension surplus had turned into a pension deficit of almost $29 billion. GE has by far the largest pension deficit of all companies in the S&P 500 — over 50% higher than Lockheed Martin or General Motors.

By 2000 most US public companies had closed off their DB plans and made substantial contributions to shore them up. But GE was late in freezing its DB plan and failed to adequately fund it. These are the types of mistakes that an effective finance committee should have been able to prevent.

Instead, the GE board approved a massive series of poorly timed buybacks and acquisitions, all of which should have been carefully vetted by a finance committee. GE’s pension deficit exploded between 2010 and 2016, as the company spent $40 billion on stock buybacks in a futile effort to boost its stock price. Similarly, the company overpaid for several problematic purchases — for example, $9.5 billion in 2015 for Alstom’s business of making coal-fired turbines for power plants.

At the same time, GE’s independent directors put no limits on the amount of GE stock held by employees in its 401(k) plan. Over one-third of this plan’s assets are invested in GE shares, which are used by the company to match employee contributions. This overconcentration in employer stock undermines the benefits of a diversified portfolio in a 401(k) plan, where participants bear the entire risk of subpar investment performance.

After the demise of Enron in 2002, many U.S. companies dropped employer stock as an investment option in their 401(k) plans. Other U.S. companies stopped using employer stock to match employee contributions, or capped the total amount of employer stock held by any 401(k) participant. None of these constraints on employer stock were adopted by the GE board for its 401(k) plan.

The board has since transformed. At the same time that it downsized, it established a finance committee in addition to its other committees. That brings us to the third problem.

The Board’s Audit Committee Wasn’t Paying Attention

While Welch bequeathed a strong pension plan to GE, he also left the company with a dubious legacy of what is now called earnings management. For almost every quarter from 1992 through 2001, GE managed to hit or just beat Wall Street’s earnings forecast for the company. Welch reportedly accomplished that feat by engaging in last-minute transactions at GE Capital to make sure the company’s overall earnings consistently met Wall Street’s expectations.

Given that history, GE’s audit committee should have been particularly vigilant about checking on the company’s practices for recognizing quarterly revenues. Yet the revenue recognition games continued until 2009, when the SEC brought an enforcement case against GE for “reporting materially false and misleading results in its financial statements.” GE settled the case by paying a $50 million fine and publicly correcting several sets of financial statements spanning the years 2001 through 2008.

In one set of violations, GE had effected December “sales” of locomotives to unnamed financial partners, who left most of the ownership risks with GE. These sales padded the company’s revenues by $381 million — enough to meet Wall Street’s expectation for GE’s annual numbers. The other violation involved incorrectly applying “cash flow” accounting to GE’s interest rate swaps in order to avoid reporting a $200 million hit to the company’s earnings.

An interesting aspect of the swaps issue was the role of KPMG, the auditors of GE. According to the SEC, although the local KPMG auditors consulted the firm’s national office on this issue, they then approved the incorrect accounting for swaps without telling the national office. After 100 years of working for GE, was KPMG too close to company management to provide the directors with an independent take on close calls?

That question is now being raised by some GE shareholders, who have recently been surprised by another major set of accounting problems. In January of 2018, GE announced that it was taking a $6.2 billion after-tax charge and contributing $15 billion over the next seven years to deal with the remaining liabilities of a long-term health insurance business that investors thought it had divested a decade ago. The SEC is investigating the process leading to this specific charge and GE’s accounting controls for service contracts.

The directors on GE’s audit committee should be very concerned that these huge remaining liabilities were not previously disclosed to investors. Now that the board has a finance committee, the audit committee should have more time to dig into the issues surrounding these liabilities as well as the company’s general procedures for recognizing revenues and losses. Perhaps the audit committee will even decide to hire a new auditing firm, which would be accountable mainly to the committee rather than to management.

In short, although Immelt was primarily responsible for running GE’s businesses, its independent directors should have been much more proactive in questioning his massive allocation of capital to acquisitions and buybacks and in probing the company’s accounting practices. But with the recent streamlining of the board and the creation of a finance committee, these directors are now in a much better position to supervise the major decisions of GE’s new CEO.

Robert C. Pozen is a senior lecturer at MIT Sloan and nonresident senior fellow at the Brookings Institution.